A growing number of bank analysts are saying the Global Credit Crisis will extend well into 2009, if not beyond.
This means more pressure on financial stocks and bank balance sheets; banks have added $25 billion to loss reserves so far, but face mounting consumer credit losses in a second wave of the crisis that some bank executives have acknowledged will be worse than the first, which has cost hundreds of billions of dollars in write-downs and losses.
Wall Street’s originate-to-distribute model, designed to mitigate risk by spreading it around, actually exacerbated those risks. It encouraged banks to loosen lending standards because more loan volume meant higher profits; then it led to over-leverage, and finally to complacency. More and more paper dollars were created for trading on the assumption that housing prices would always go up.
The first wave of the crisis affected trading books, but the second will hit lending.
As long as housing values were rising, borrowers could refinance in perpetuity to avoid default. Losses mounted when the refinancing option disappeared. Banks relied too heavily on the securitization markets to boost lending to consumers, particularly in the form of mortgages.
In time, some lending will return, but the sky-high revenues of recent years will be hard to reclaim.
The banking sector’s pullback in lending will cause further painful losses. Many believe banks will have to reserve an additional $170 billion through the end of next year just to keep up with estimated loan losses. “New and unforeseen strains on consumer liquidity will push more consumers into precarious credit positions and cause consumer credit losses to be far worse than what is currently estimated, even by the most draconian of investors”.
Here in Canada, an accepted truism of the global banking crisis is that the big Canadian banks have done rather better than their global peers, avoiding the worst of the writedowns.
Commentators and analysts have spouted words of comfort about the Canadian banking sector for months, and even Federal Finance Minister Jim Flaherty noted in April after meeting the big bank chiefs in Toronto that Bay Street has avoided the worst pitfalls that have beset banks elsewhere.
But that idea is becoming increasingly difficult to uphold as a few of the Canadian banks ratcheted up their losses in second-quarter results announced this week.
Almost all the bank chiefs warned, too, about slowing capital markets and rising loan losses.
The notion that Canada's banks are relatively unscathed is starting to look like misplaced optimism.
Royal Bank of Canada, the country's biggest bank, confirmed Thursday that its writedowns on structured products now stand at $1.6-billion - a sum that would have been unthinkable last year when Canada's banking sector was on a long winning streak.
RBC chief Gord Nixon was "not happy" about his bank's writedowns, but you have to wonder what he thought of the charges at Canadian Imperial Bank of Commerce, which now total $6.7-billion after the bank acknowledged its investments in structured products produced another $2.5-billion in losses in the second quarter.
RBC and CIBC now share the ignominy of featuring among the global banking top 40 for largest writedowns and credit losses since the banking sector was thrown into crisis last year. (Writedowns refer to structured products being marked to market value, whereas credit losses reflect expected and actual loan defaults.)
RBC sits at number 40 and CIBC's latest charges mean it has leapfrogged up the league table [according to the latest data from Bloomberg], moving into 16th spot above Germany's West LB -- which has taken US$4.8-billion in writedowns and is the subject of a European Union bailout plan -- and Societe Generale, which has incurred US$6.3-billion in writedowns.
In proportion to the size of the bank's assets before the full impact of the crisis hit last year, CIBC's losses are as bad as those of UBS -- the Swiss bank that has suffered US$38.2-billion in writedowns -- and worse than the losses recorded by HSBC Holdings (US$19.5-billion) and JP Morgan Chase & Co. (US$9.7-billion). CIBC's losses as a proportion of total assets are almost as severe as those of Citigroup Inc. (US$43-billion) the poster child for the financial crisis.
Picking on RBC and CIBC alone highlights an important point -- not all Canadian banks are equal when it comes to the financial crisis. Toronto-Dominion Bank has supposedly incurred no writedowns. Bank of Montreal, National Bank of Canada, and Bank of Nova Scotia escaped major writedowns this quarter, but their combined writedowns on structured products stand at more than $1.8-billion since the crisis began.
Leaving writedowns aside, Canadian bank CEOs have painted a bleak picture this week for their outlook on the remainder of 2008.
Even Toronto-Dominion Bank chief Ed Clark -- one of the few CEOs in North America or Europe who can truly claim to have steered his bank through the financial crisis without taking a big hit -- is projecting no earnings growth in 2008 for his bank, amid rising loan losses, stifled investment banking activity, and the potential spillover from the U.S. economic slowdown into Canada.
Still, there are some positives for the Canadian banks.
Their writedowns are so far on paper only, and if the market for certain structured products turns around they will reverse some of their losses, as BMO did this week, announcing it made a gain of $42-million on investments that had previously been written down.
More importantly perhaps, Canada has so far not seen a house price slump like the U.S. and some parts of Europe.
Certainly some Canadian banks are exposed to the collapse of the U.S. housing market through their U.S. subsidiaries -- notably RBC bumped up the provision for loan losses at its bank in Florida and other southern states. But the biggest advantage the Canadian banks have over their peers around the world is the strength of the Canadian economy and their strong domestic retail operations. Let's hope this continues.
Friday, May 30, 2008
Tuesday, May 27, 2008
Higher Oil Prices Not Necessarily Shocking.
Much has changed in the decades since embargoes and war in the Middle East upset oil markets.
We've become much more energy efficient. Computers have made us more productive. And we've learned to temper our inflation expectations.
Consider that gleaming stainless steel refrigerator in your kitchen.
It isn't just the colour that has changed since you were a kid.
The average refrigerator is 70 per cent more energy efficient and nearly a third larger than in the early 1970s.
The transformation goes a long way to explaining why oil at more than $130 (U.S.) a barrel isn't likely to rattle the global economy as badly as the oil shocks of the 1970s and 1980s. The same holds true for cars, air conditioners and many other energy-sucking machines.
"Despite the surge in oil prices this decade, there are scant signs that the current oil shock is affecting the global economy in a manner similar to the 1970s," according to a report last week by Goldman Sachs economist Jim O'Neill.
It's true that the magnitude of the price spike is impressive. Oil is up nearly 50 per cent this year and 85 per cent in the past two years.
And adjusted for inflation, oil has never been this expensive.
But for pure shock value the recent runup pales compared to 1973 when oil shot up nearly fivefold (to $12 a barrel from $2.50), or 1979 when the price of oil more than tripled (to $40 a barrel from $12).
More importantly, the economy is better equipped to withstand energy price surges. It now takes about half as much energy to produce a dollar of gross domestic product than it did in the early 1970s.
Over the past three decades, global energy intensity - energy consumption as a percentage of GDP - has declined 1.5 to 2 per cent a year. And today's high energy prices are likely to make us even greener by spurring a new round of conservation and energy efficiency.
Already, there are tentative signs that consumers are reacting to higher pump prices. In recent weeks, U.S. sales of sport utility vehicles and pickup trucks have fallen sharply. Gas demand is also down a bit, but consumption has proven to be stubbornly inelastic in recent years. Longer term, higher vehicle fuel economy standards would significantly curb per capita consumption in Canada and the United States - the two biggest energy guzzlers among the world's largest industrialized economies.
A lot more needs to happen. Goldman Sachs points out that Japan has been leading the way in reducing its dependence on foreign oil. If the United States, Russia, China and India matched those gains, global energy consumption could be cut by 20 per cent. The latter three have not had the infrastructure of oil dependency and addition ingrained into their culture--yet.
Countries must resist the temptation to limit the price of gas. And countries such as China, which already caps gasoline prices, should relax those controls and let prices rise. This will encourage conservation and spur the search for alternatives.
Energy efficiency is only part of the reason we're better off than in the 1970s.
Our economies are more knowledge-based than industrial-based. The service sector has taken over from manufacturing as the primary economic driver.
As a result, the consumption of oil - and energy in general - is less of a burden on the economy.
In the United States, for example, oil consumption sucks up 5.75 per cent of GDP, compared with 7.5 per cent in 1980.
By that measure, it would take a price of $172 a barrel to feel like 1980.
Even then, it's unlikely that high prices will unleash the kind of virulent inflation that occurred in the past. The simple answer is that inflation expectations are much lower now. Neither consumers, businesses, nor investors expect to be paying substantially more for most of the stuff they buy in the months ahead.
"Inflation expectations are much better anchored now than they were in the 1970s and 1980s," according to Goldman Sachs.
Assuming the world's major central banks are successful in keeping inflation at bay, pricey oil could have a silver lining.
Conservation and efficiency will cut carbon-dioxide emissions and make the planet cleaner. The market is sending clear signals. We just need to heed them.
Governments must avoid the temptation to intervene, except to aid those least able to cope. Consumers must continue to make wise energy choices. And producers must reinvest more of their profits into the quest for unconventional and alternative energy sources.
That will keep this shock from becoming truly shocking.
We've become much more energy efficient. Computers have made us more productive. And we've learned to temper our inflation expectations.
Consider that gleaming stainless steel refrigerator in your kitchen.
It isn't just the colour that has changed since you were a kid.
The average refrigerator is 70 per cent more energy efficient and nearly a third larger than in the early 1970s.
The transformation goes a long way to explaining why oil at more than $130 (U.S.) a barrel isn't likely to rattle the global economy as badly as the oil shocks of the 1970s and 1980s. The same holds true for cars, air conditioners and many other energy-sucking machines.
"Despite the surge in oil prices this decade, there are scant signs that the current oil shock is affecting the global economy in a manner similar to the 1970s," according to a report last week by Goldman Sachs economist Jim O'Neill.
It's true that the magnitude of the price spike is impressive. Oil is up nearly 50 per cent this year and 85 per cent in the past two years.
And adjusted for inflation, oil has never been this expensive.
But for pure shock value the recent runup pales compared to 1973 when oil shot up nearly fivefold (to $12 a barrel from $2.50), or 1979 when the price of oil more than tripled (to $40 a barrel from $12).
More importantly, the economy is better equipped to withstand energy price surges. It now takes about half as much energy to produce a dollar of gross domestic product than it did in the early 1970s.
Over the past three decades, global energy intensity - energy consumption as a percentage of GDP - has declined 1.5 to 2 per cent a year. And today's high energy prices are likely to make us even greener by spurring a new round of conservation and energy efficiency.
Already, there are tentative signs that consumers are reacting to higher pump prices. In recent weeks, U.S. sales of sport utility vehicles and pickup trucks have fallen sharply. Gas demand is also down a bit, but consumption has proven to be stubbornly inelastic in recent years. Longer term, higher vehicle fuel economy standards would significantly curb per capita consumption in Canada and the United States - the two biggest energy guzzlers among the world's largest industrialized economies.
A lot more needs to happen. Goldman Sachs points out that Japan has been leading the way in reducing its dependence on foreign oil. If the United States, Russia, China and India matched those gains, global energy consumption could be cut by 20 per cent. The latter three have not had the infrastructure of oil dependency and addition ingrained into their culture--yet.
Countries must resist the temptation to limit the price of gas. And countries such as China, which already caps gasoline prices, should relax those controls and let prices rise. This will encourage conservation and spur the search for alternatives.
Energy efficiency is only part of the reason we're better off than in the 1970s.
Our economies are more knowledge-based than industrial-based. The service sector has taken over from manufacturing as the primary economic driver.
As a result, the consumption of oil - and energy in general - is less of a burden on the economy.
In the United States, for example, oil consumption sucks up 5.75 per cent of GDP, compared with 7.5 per cent in 1980.
By that measure, it would take a price of $172 a barrel to feel like 1980.
Even then, it's unlikely that high prices will unleash the kind of virulent inflation that occurred in the past. The simple answer is that inflation expectations are much lower now. Neither consumers, businesses, nor investors expect to be paying substantially more for most of the stuff they buy in the months ahead.
"Inflation expectations are much better anchored now than they were in the 1970s and 1980s," according to Goldman Sachs.
Assuming the world's major central banks are successful in keeping inflation at bay, pricey oil could have a silver lining.
Conservation and efficiency will cut carbon-dioxide emissions and make the planet cleaner. The market is sending clear signals. We just need to heed them.
Governments must avoid the temptation to intervene, except to aid those least able to cope. Consumers must continue to make wise energy choices. And producers must reinvest more of their profits into the quest for unconventional and alternative energy sources.
That will keep this shock from becoming truly shocking.
Tuesday, May 13, 2008
Capital Flight or Foreign Investment -- or History?
There are mixed signals for the global economy.
As recently as ten years ago, emerging markets still held their hands out for development loans and foreign aid. Today, their fiscal prudence and wealth has put them in the position of bailing out the western banking system.
Why are investors taking so long to realize this critical distinction and its meaning?
Inflation is rising at a time of global slowdown. The US economy is weakening while commodities soar. There may be both inflation and slow growth in the US, and maybe also in Europe, but both the growth and inflation pictures may look very different in emerging markets. From low levels, inflation has risen with strong upsurges in domestic demand in emerging markets. However, growth will continue to be robust, if slightly down.
Resurgent inflation is a more global problem in my view than slowdown, which appears to be largely limited to the US, albeit with possible spillovers to Europe coming.
Gross national savings are over 30 per cent of GDP on average in emerging countries, and for a decade private and official savers in these countries have been investing overseas – in the US and Europe – under the impression that these were safer markets than at home.
Yet the dollar is far from the safest currency and not the store of value it was. US Treasuries are not zero risk – the implicit myth in the term “the risk-free rate”. Treasuries have currency, curve and volatility risks. Investors in triple A structured credit got a shock when they realised their investment was risky. Likewise emerging market savers are getting a shock about Treasuries and other US and European assets.
The money is returning home, and the move is structural, not cyclical.
The global imbalance of a negative US personal savings rate on the one hand being financed by high emerging savings on the other is starting to reverse. With this reversal, or rebalancing, is coming, I believe, a currency realignment and a series of investment booms across emerging economies as investment focus shifts. Rather than using “decoupling” in describing the impact of the credit crunch on emerging markets, we should use “negative correlation”.
Many central banks in emerging markets know the costs of inflation and the need to move fast in preventing it. The widespread implicit assumption that emerging market central banks will simply allow inflation to rise without taking action is broadly incorrect in my view. In some countries interest rates have started to rise and exchange rates also, though both these dynamics have further to go.
Whatever the choices of individual countries, the logic of global rebalancing remains: if the rest of the world is tiring of financing the US, then the US current account deficit has to shrink and US goods and services need to become cheaper in real terms vis-à-vis emerging goods and services. It is not credible that the world will revert to the same level of capital flows to the US after the credit crunch is over. The least painful way to do this is through gradual exchange rate appreciation of emerging currencies.
The policy asymmetry between the US and emerging markets is that the emerging markets, with undervalued currencies, have an additional degree of freedom. They have the choice to mess up (do nothing) or control inflation (let the currency rise, raise interest rates). I believe that emerging market central banks will largely pass this test and do the sensible thing, though this is not what the market appears to have priced in yet.
The US must hope for the best. Ben Bernanke, chairman of the Federal Reserve, has focused on lower rates to cope with a slowdown. If currency weakness is gradual over the next couple of years, this will cause gradual importation of inflation, balanced by the US domestic slowdown’s deflationary impact. If, however, currency adjustment is quick, the US has little policy scope to avoid stagflation.
The most important impact of the credit crunch on emerging markets may be through asset allocation, starting with an inflow into emerging local currency debt, and then real investments. The emerging market private and public sector investor has for years been investing overseas: into the US and Europe. This has been to reduce risk, to get out of the home market.
This used to be called capital flight, is now called foreign investment, and may shortly be history.
As recently as ten years ago, emerging markets still held their hands out for development loans and foreign aid. Today, their fiscal prudence and wealth has put them in the position of bailing out the western banking system.
Why are investors taking so long to realize this critical distinction and its meaning?
Inflation is rising at a time of global slowdown. The US economy is weakening while commodities soar. There may be both inflation and slow growth in the US, and maybe also in Europe, but both the growth and inflation pictures may look very different in emerging markets. From low levels, inflation has risen with strong upsurges in domestic demand in emerging markets. However, growth will continue to be robust, if slightly down.
Resurgent inflation is a more global problem in my view than slowdown, which appears to be largely limited to the US, albeit with possible spillovers to Europe coming.
Gross national savings are over 30 per cent of GDP on average in emerging countries, and for a decade private and official savers in these countries have been investing overseas – in the US and Europe – under the impression that these were safer markets than at home.
Yet the dollar is far from the safest currency and not the store of value it was. US Treasuries are not zero risk – the implicit myth in the term “the risk-free rate”. Treasuries have currency, curve and volatility risks. Investors in triple A structured credit got a shock when they realised their investment was risky. Likewise emerging market savers are getting a shock about Treasuries and other US and European assets.
The money is returning home, and the move is structural, not cyclical.
The global imbalance of a negative US personal savings rate on the one hand being financed by high emerging savings on the other is starting to reverse. With this reversal, or rebalancing, is coming, I believe, a currency realignment and a series of investment booms across emerging economies as investment focus shifts. Rather than using “decoupling” in describing the impact of the credit crunch on emerging markets, we should use “negative correlation”.
Many central banks in emerging markets know the costs of inflation and the need to move fast in preventing it. The widespread implicit assumption that emerging market central banks will simply allow inflation to rise without taking action is broadly incorrect in my view. In some countries interest rates have started to rise and exchange rates also, though both these dynamics have further to go.
Whatever the choices of individual countries, the logic of global rebalancing remains: if the rest of the world is tiring of financing the US, then the US current account deficit has to shrink and US goods and services need to become cheaper in real terms vis-à-vis emerging goods and services. It is not credible that the world will revert to the same level of capital flows to the US after the credit crunch is over. The least painful way to do this is through gradual exchange rate appreciation of emerging currencies.
The policy asymmetry between the US and emerging markets is that the emerging markets, with undervalued currencies, have an additional degree of freedom. They have the choice to mess up (do nothing) or control inflation (let the currency rise, raise interest rates). I believe that emerging market central banks will largely pass this test and do the sensible thing, though this is not what the market appears to have priced in yet.
The US must hope for the best. Ben Bernanke, chairman of the Federal Reserve, has focused on lower rates to cope with a slowdown. If currency weakness is gradual over the next couple of years, this will cause gradual importation of inflation, balanced by the US domestic slowdown’s deflationary impact. If, however, currency adjustment is quick, the US has little policy scope to avoid stagflation.
The most important impact of the credit crunch on emerging markets may be through asset allocation, starting with an inflow into emerging local currency debt, and then real investments. The emerging market private and public sector investor has for years been investing overseas: into the US and Europe. This has been to reduce risk, to get out of the home market.
This used to be called capital flight, is now called foreign investment, and may shortly be history.
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